The Ultimate Guide to Stablecoins

It’s true that Bitcoin revolutionized the financial industry and provided society with a new perspective on decentralized payments and peer-to-peer transactions. Bitcoin also gave rise to a digital store of value that was never before possible, but the need for a bridge between fiat and crypto assets with was needed, which led to the rise of stablecoins.

This guide to stablecoins will cover the following topics:

• What are stablecoins?
• The major types of stablecoins
• How stablecoins work
• Why stablecoins are important
• Where to buy stablecoins

Though I am a huge fan of Bitcoin, there are some use cases it cannot fulfill. For example, you don’t often see people buying things like coffee with Bitcoin and there is a reason for that. The Lightning network did make bitcoin accessible for small transactions, but it isn’t suitable as a currency for the following reasons:

• Transactions can cost anywhere from a few cents to over $50 during peak network congestion like we saw during the 2021 bull run. A $50 network fee to buy a $1 coffee? No thanks.
• Transactions can take over 10 minutes to finalize. Imagine paying for your coffee and then waiting 10 minutes to see if your payment was successful.
• Bitcoin is too volatile for many merchants to want to accept it. If 100 people buy coffee in a day using Bitcoin, the price drops 10%, significantly impacting the profit margin. Volatile assets also make it impossible for business owners to budget and know how much BTC needs to be set aside for payroll, bills, etc.
• Finally, many Bitcoin enthusiasts consider Bitcoin to be the “apex property” of the human race, the most important invention of our generation, and the most valuable thing we have created. It is held onto by many as an inflation hedge and an investment, often considered far too valuable to be used on daily purchases.

This is just one of the areas where stablecoins offer an attractive alternative. They also provide the liquidity needed for trading, can protect digital asset holders from downside volatility, provide a convenient way to store value after the selling of other digital assets, and provide a digital medium of exchange.

We are seeing a massive rise in stablecoin adoption from e-commerce sites, online businesses, and in countries where the currency is being devalued by inflation, resulting in people flocking to stablecoins to preserve their purchasing power.

What are Stablecoins?

Stablecoins are digital currencies minted on the blockchain and pegged to or backed by physical assets such as fiat or gold to retain a stable value. Users can buy, sell, and trade stablecoins just like any other crypto assets and self-custody them by storing them in their cryptocurrency wallets.

Two of the most popular stablecoins are USDT and USDC, both are pegged 1:1 to the United States dollar and are backed by cash, cash equivalents, commercial paper, corporate bonds, loans, and other investments as collateral.

Here is a look at the ten largest stablecoins by market cap:

Here are the common types of stablecoin collateral:

• Fiat- The most common collateral for stablecoins. The US dollar is the most widely used by a significant margin, but many other national currencies are also held for their digital counterparts.
• Precious metals- Some crypto is tied to the value of metals such as gold or silver.
• Cryptocurrencies- Some stablecoins use other cryptocurrencies like Ethereum as collateral. These stablecoins are normally overcollateralized to combat price volatility.
• Other Investments- Companies that issue stablecoins can often hold a mix of investments as collateral such as commercial paper, corporate debt, bonds, loans, and other “approved investments.”

These collateralized assets are held in reserves and help to ensure that 1 USDC or USDT is always equal to $1. Stablecoins aim to offer the benefits of both fiat and cryptocurrencies such as the high speed, security, and efficiency of crypto, along with the price stability of fiat currencies.

Other examples of stablecoins are:

• Tether Gold (AUXT)- Pegged to gold’s price
• Tether Euro (EURT)- Pegged to the Euro
• Tether Peso (MXNT)- Pegged to the Mexican Peso
• DAI- Decentralized stablecoin issued by MakerDAO

And the list goes on. There are stablecoins pegged to many nations’ currencies, providing people with a chance to swap their national fiat currency for the equivalent amount of digital currency.

There are also more complex types of stablecoins that are collateralized by baskets of other cryptocurrencies or partially algorithmic or hybrid, but these are still yet to be proven successful and have not gained mainstream adoption.

Most stablecoins are issued by an entity or company that is responsible for managing the issuance schedule and ensuring that they are holding enough assets in reserves to adequately back the stablecoin. The four largest stablecoin issuers are Circle, Paxos, Tether, and Binance.

Due to the unpredictable and fluctuating nature of cryptocurrencies, stablecoins hold a stable value making them more suitable for everyday use.

To showcase this point, here is an interesting graph showing the daily percentage returns on Bitcoin/Canadian dollar vs the US/Canadian dollar, showing how much Bitcoin fluctuates in relation to traditional currencies from 2016-2021

With many companies running on tight profit margins and people living paycheck to paycheck, you can see why relying on an asset with so much volatility starts to have its issues.

Check out Guy's take on Stablecoin risks below if you want another perspective:

The US fiat-pegged stablecoin Tether (USDT) is widely considered to be the first stablecoin and became the most widely traded cryptocurrency in the world in 2020.

Some of the reasons for this are that many traders like to trade a crypto asset like Bitcoin against Tether, winning trades are often cashed out in Tether, e-commerce and online businesses started adopting stablecoins, and the global population finally had easy access to the US dollar and were keen to ditch their national currency for the stronger greenback.

The chart above shows how dominant Tether’s USDT stablecoin was in 2020 and how it has started losing market share as other stablecoins were created. People also started moving to other stablecoins like USDC as there were plenty of scandals regarding USDT, suspicion, and accusations that Tether did not hold adequate reserves to back all the USDT in circulation.

Fiat-Backed Stablecoins

This is the most common method of backing up popular stablecoins. There are stablecoins linked to many of the major fiat currencies.

Here is a look at Tether’s 2024 consolidated reserves report showing what is backing the USDT Stablecoin:

Cryptocurrency-Backed Stablecoins

Some stablecoins are pegged to the value of other well-established cryptocurrencies or backed by overcollateralized cryptocurrency reserves. A simple example of this would be a stablecoin whose value is $1 and is backed by Bitcoin, meaning that a holder could always redeem the coin for $1 worth of Bitcoin currency.

To adequately back the coins, the issuer would have to maintain a reserve of Bitcoin substantially larger than the value of issued coins so that if the value of Bitcoin dropped, the issuer could still buy back all the issued stablecoins with Bitcoin.

MakerDAO’s DAI stablecoin is an example of a token that does this with Ethereum. Dai is the most popular decentralized stablecoin that runs on Ethereum and attempts to maintain a value of $1. Unlike centralized stablecoins, Dai isn’t backed by US dollars held in reserves but by collateral on the Maker platform that is deposited by users.

Commodity-Backed Stablecoins

These stablecoins are pegged to the value of commodities like precious metals, industrial metals, oil, or even real estate. These provide investors an incredibly convenient and easy way to gain exposure to commodity investments without needing to source or store the commodity. 

Many investors believe that someday, every investible asset will have its value stored and available on the blockchain, it will be called tokenized Real-World Assets (RWAs).

Some cryptocurrencies have been created based on the value of an index consisting of multiple commodities. Gold-backed stablecoins like PAXG are the most common commodity-backed cryptocurrencies, but there are also assets like Tiberius, which is backed by a combination of seven precious metals, or SwissRealCoin, which is pegged to the value of a portfolio consisting of Swiss real estate.

Algorithmic Stablecoins

Algorithmic stablecoins are not backed by anything and rely on algorithms to regulate the supply based on market demand. These algorithms will automatically burn or mint new coins based on fluctuating demand for the stablecoin at the current time.

It is also worth mentioning that a newer kind of stablecoin, called Fractional Algorithmic Stablecoins or Hybrid Stablecoins, was introduced. These are partially backed by collateral and partially stabilized algorithmically. The price is supported by a flexible collateral mix comprising other stablecoins and a separate “seigniorage token.” These are not commonly used or adopted, something that may change. A famous example of this hybrid stablecoin is Frax.

Yield-Bearing Stablecoins

Yield-bearing stablecoins (YBS) are a specialized type of stablecoin designed to generate returns for their holders. Unlike traditional stablecoins, which are pegged to a fiat currency (like USD) and aim to maintain a stable value without accruing interest, YBS are structured to provide passive income. They achieve this by employing various yield-generating strategies, such as leveraging decentralized finance (DeFi) platforms, crypto derivatives, and investments in traditional financial instruments like U.S. Treasuries and bank deposits. This approach allows investors to earn interest or dividends while maintaining the stability of the underlying asset, effectively merging the benefits of stable value and income generation.

What Does Yield-Bearing Stablecoins Offer Over Traditional Stablecoins?

Passive Income

Yield-bearing stablecoins provide an opportunity to earn passive income on holdings. Traditional stablecoins like USDT or USDC do not offer returns and are used as a means of value transfer or storage. YBS, however, are designed to generate yield, making them a more attractive option for investors looking for additional returns on their assets.

Diversification of Returns

YBS offers diversified income streams by engaging in different yield-generating activities. For instance, some YBS, like sDAI from MakerDAO, earn interest from the Dai Savings Rate (DSR) by depositing DAI in a smart contract that accrues interest. Others, like Ethena's USDe, leverage delta-neutral strategies to earn yield from funding rates and basis spreads in the derivatives market. Ondo Finance's USDY generates yield by investing in traditional financial instruments such as short-term U.S. Treasuries and bank deposits. These varied approaches provide different risk and return profiles, enabling investors to diversify their income sources.

Enhanced Stability and Accessibility

By incorporating traditional financial assets like U.S. Treasuries, YBS can offer greater stability than regular stablecoins relying purely on crypto-based collateral. This is particularly evident in Ondo Finance’s USDY, which provides yield from government-backed securities, ensuring a more stable and predictable return. Furthermore, platforms offering YBS, like Ondo Finance, ensure compliance with regulatory standards, making them accessible to a broader range of risk-averse investors.

What are the Top Yield-Bearing Stablecoin Projects?

• sDAI (Spark Protocol): sDAI is a yield-bearing stablecoin from MakerDAO, tied to the Dai Savings Rate (DSR). Users deposit DAI into the DSR smart contract and receive sDAI in return, which represents their deposit. sDAI accrues interest over time based on the DSR, allowing holders to earn yield. This stablecoin is ideal for investors seeking stable returns with exposure to DeFi mechanisms. However, it comes with risks related to the alignment of incentives between DSR returns and MKR governance decisions.
• USDe (Ethena Finance): USDe is a stablecoin from Ethena Finance that generates yield through a delta-neutral hedging strategy. By balancing long and short positions on Ethereum derivatives, Ethena ensures the stability of USDe while earning positive funding rates and basis spreads. This strategy is particularly effective in market conditions with high leverage demand and moderate volatility, making USDe an attractive option for those seeking to capitalize on specific market conditions without exposure to price volatility.
• USDY (Ondo Finance): USDY is an interest-bearing stablecoin offered by Ondo Finance, backed by short-term U.S. Treasuries and bank deposits. It provides a stable yield derived from traditional financial instruments, appealing to risk-averse investors looking for predictable returns. USDY’s design ensures that the majority of the yield is passed directly to holders, with a focus on regulatory compliance and operational security, making it a solid choice for those looking to bridge the gap between TradFi and DeFi.

Yield-bearing stablecoins present a compelling alternative to traditional stablecoins by offering stable value with added benefits of passive income and diversified yield sources. Projects like sDAI, USDe, and USDY cater to different investor needs, providing a range of risk and return profiles that can be tailored to various market conditions and investment strategies. As the DeFi ecosystem continues to evolve, YBS are likely to play an increasingly prominent role in providing secure and profitable options for a wide range of investors.

How Stablecoins Work

Typically, the entity or company behind a centralized stablecoin will set up a reserve to securely store the asset or basket of assets that back the stablecoin. Audits are performed regularly on major stablecoin issuers like Tether, Circle, and Paxos to ensure they hold enough assets in reserves to cover the value of the stablecoins they issue.

This ensures that stablecoins are pegged to real-world assets. The money in reserves serves as collateral for the stablecoin, so whenever a stablecoin holder cashes out their tokens, an equal amount of whatever asset backs it is taken from the reserve, ensuring the peg remains balanced and stable.

The peg does not always stay perfectly balanced; stablecoin prices can and often do fluctuate from the associated fiat price by a percent or two, far less than the fluctuations experienced by other crypto assets.

While most stablecoins are highly centralized, MakerDAO provides a decentralized approach to stablecoins and is the most prominent example. MakerDAO is run by a decentralized autonomous organization (DAO) and issues DAI stablecoins to borrowers, ensuring its reserve assets are always overcollateralized. Overcollateralization means the reserve holds more assets than DAI’s total supply value. Maker only holds cryptocurrencies such as Ethereum and USDC in the reserves.

Maker users lock up their crypto collateral in a smart contract. Once the contract knows the collateral is secure, users can borrow freshly minted DAI stablecoin tokens.

Then, we have algorithmic stablecoins that, instead of collateral, rely on algorithm-induced arbitrage opportunities between stablecoins and other assets to stabilize their value.

While algorithmic stablecoins may sound solid in practice and like a great idea, as they work on simple supply-and-demand economics, this type of protocol has proven incredibly difficult to get right.

Algorithmic stablecoins have been attempted multiple times, with multiple failures and lost billions of dollars worth of customer assets. The Terra Luna collapse is the most damaging example, as billions were lost with many people losing their life savings.

The historic Luna collapse will become one of the darkest days in crypto history. An estimated $60 billion was wiped out during the collapse, sparking regulatory action and panic among investors and global regulators. The failed project led many to believe that the possibility of a successful algorithmic stablecoin is unlikely. Time will tell.

Benefits of Stablecoins

Stablecoins complement our ever-increasing global economy and digital age. Stablecoins prove a solution to some key problems that stifle the exchange of money:

1. Stablecoin users do not need international bank accounts or rely on banks to send money cross-border. All that is required is a crypto wallet, and funds are sent instantaneously. This is a massive improvement over the slow, expensive, and prohibitive legacy system.
2. Stablecoins make peer-to-peer digital transfers possible without the need for third-party intermediaries.
3. Stablecoins reduce fees and transfer times and eliminate much of the red tape that often comes with international exchanges.
4. Stablecoins can be utilized without needing KYC, enhancing privacy and anonymity. However, it is important to note that blockchain transactions can be traced and tracked, and centralized stablecoin transactions can be halted and controlled due to their centralization. Despite all this, utilizing stablecoins remains significantly more private than going through the banking system. For now.

The primary goal of a stablecoin is to deliver the benefits of blockchain digital assets in a currency that isn’t affected by substantial price rises and decreases.

Stablecoin Drawbacks

Stablecoins are not without their pain points and have certain drawbacks to be aware of.

If the issuing company stores its reserves with a bank or a third party, counterparty risk is present. Funds are at risk if the bank goes insolvent or there is a security exploit. This doesn’t just apply to stablecoins; anytime you trust any authoritative entity with anything, there is an element of third-party risk.

Regulatory risk is also a big one with stablecoins. Global regulators and governments are watching stablecoins very closely, as they are disrupting the financial system and posing a systemic threat in many ways. Tens of billions of dollars flow from the traditional banking system into stablecoins.

It is not yet known how regulators will approach the stablecoin situation. They likely do not appreciate the loss of control over a monetary system, and their plans to roll out their own CBDCs may significantly impact the future of stablecoins.

On the flip side, US regulators are especially in a tricky spot as global adoption of US-backed stablecoins is increasing the global reliance on USD, which is good for the US dollar. However, the adoption is of a version of the US dollar that they do not control, which is a concern. Regulators have a tough choice balancing what is best for the global dependence on the US dollar and how much control they will give up.

A core ethos of cryptocurrency is the ability not to trust but to verify. Thanks to blockchain technology, features and aspects of transactions and token issuance details are entirely transparent and verifiable by anyone. This leads crypto users not to need to trust other people or entities, as they trust the code, the algorithms, and the blockchain. Centralized stablecoins require trust in the issuing company, which is a concern for many.

Stablecoins generally require a custodian to regulate the currency and maintain fiat reserves. This means that users need to rely on the honesty and integrity of the issuing party when honoring deposits and withdrawals. Stablecoins are primarily centralized and require third-party trust, and the company can block and control transactions behind some stablecoins. These features all go against the true ethos of cryptocurrency, which is why there is a strong desire for an algorithmic stablecoin that works.

Then, of course, the final drawback comes from algorithmic stablecoins. When too much liquidity is taken from a stablecoin market too quickly, the price of the peg can drop, which spooks investors, who also go to sell, dropping the price even more and causing what is known as a death spiral as we saw with the above charts of Terra Luna's token.

Many people held a significant portfolio value in Terra Luna, only to watch it go to zero. Algorithmic stablecoins are something to be very wary of until someone comes up with a working model for creating one.

How to Buy Stablecoins

Stablecoins are available on pretty much every cryptocurrency exchange and DEX. They are the most common instrument for trading cryptocurrencies against and provide traders with a stable store of value and medium for exchange. Therefore, some form of stablecoin is supported anywhere that crypto can be traded.

I recommend buying stablecoins on Binance, as it is highly secure, regulated, and reputable. It is also the #1 crypto exchange in the world for a reason. Users can buy stablecoins on Binance via debit/credit card or through bank wires/transfers. You can learn more about Binance and purchasing methods in our dedicated Binance review. For users in the US, Coinbase or Kraken may prove to be ideal choices.

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Stablecoins: Closing Thoughts

As crypto adoption continues to grow and further utility is rolled out, stablecoins will play an ever-increasing role in the industry. Stablecoins provide the perfect blend of a stable-priced asset that benefits from blockchain technology. Stablecoins are a crucial part of the crypto ecosystem; without them, cryptocurrency would not be where it is today. Stablecoins bridge the gap between TradFi and DeFi and are necessary for liquidity and increasing global crypto adoption.

The major downside is the heavy centralization inherent in stablecoins, which contradicts why many of us are attracted to the crypto industry in the first place. Time will tell if centralized stablecoins are the future or if CBDCs will knock stablecoins out of the running. Many crypto users have their fingers crossed that someone will crack the decentralized algorithmic stablecoin problem once and for all, providing the industry with a robust and trustworthy decentralized stablecoin.